Microsoft's Profit Crushes Estimates

Microsoft reported first-quarter results Thursday that handily surpassed Wall Street estimates and its own guidance, thanks in part to its switch to a subscription licensing model. The software behemoth also issued strong revenue guidance, throwing water on some late-session rumors about light sales numbers. However, its earnings forecast for the fourth quarter came in below Wall Street expectations.

In after-hours trading, Microsoft was up 5.5%.

For the fiscal first quarter ended in September, the Redmond, Wash.-based company registered net income of $2.73 billion, or 50 cents a share, including an after-tax charge for investment impairments of $291 million, or 5 cents a share. Analysts surveyed by Thomson Financial/First Call were expecting Microsoft to earn 43 cents a share, the high end of the company's guided range of 42 cents to 43 cents a share.

The latest results topped net income of $1.28 billion, or 23 cents a share, in the same period a year ago. Excluding a one-time charge, year-earlier net income was 43 cents a share.

Microsoft's guidance for the second quarter targeted revenue ranging from $8.5 billion to $8.6 billion and earnings per share ranging from 45 cents to 46 cents. Wall Street was expecting second-quarter earnings of 50 cents a share and revenue of $8.43 billion.

For the full fiscal year, Microsoft said revenue would range from $32.2 billion to $32.6 billion, higher than previous guidance of $31.4 billion to $32 billion. Earnings are expected to range from $1.89 to $1.95 a share, also higher than the previous range of $1.85 to $1.91 a share. The consensus estimate is for Microsoft to earn $1.90 a share on $31.78 billion in fiscal year 2003.

For the latest quarter, Microsoft said revenue rose 26% to $7.75 billion from $6.13 billion reported a year ago, and 7% from $7.25 billion reported the previous quarter. The consensus estimate on Wall Street pegged first-quarter revenue at $7.12 billion, slightly higher than the company's guided range of $7 billion to $7.1 billion.

In the regular trading session, shares of Microsoft rose 34 cents, or 0.7%, to close at $50.75. Shares were hit at the end of trading by rumors of the company reporting light revenue. In after-hours trading, shares were up $2.79 to $53.20.

"Results for the first quarter were exceptionally strong, exceeding our expectations," CFO John Connors said in a statement. "During the quarter we saw broader customer adoption of our licensing programs than we anticipated."

Connors was referring to a change in the company's licensing system to an annuity-based, subscription program. Microsoft set a July 31 deadline for business customers to switch to that new payment plan and upgrade their software or else pay higher upgrade prices in the future.

That switch also drove a large increase in the company's unearned revenue balance, which was being watched by analysts because it also accounts for roughly one-fifth of revenue recognized on the company's income. Unearned revenue increased to $9.13 billion from $7.74 billion on June 30.

On a postclose earnings call, Connors cautioned investors to expect unearned revenue to drop slightly sequentially in the next two quarters as customer purchasing returns to more modest levels.

"The unearned revenue beat even the most bullish expectations," said Tony Ursillo, an analyst at Loomis, Sayles & Co., which holds shares of Microsoft among the $10 billion in equities it manages. "It means that essentially the company has this big barrel of future earnings that will allow it to continue to make numbers for several quarters into the future."

A preliminary review of Microsoft's results by business division also led Ursillo to believe that the change in licensing model was largely responsible for the company's strong results. He noted that revenue from Windows and servers were both strong, which would at least be partially driven by sales tied to the new payment program.

For the first time, Microsoft broke down revenue according to new divisions unveiled in its last conference call. The results include:

"Client" revenue, which represents sales of Windows products, rose 33% year over year to $2.85 billion. The company previously forecast that client revenue would grow almost 20% in the first quarter, and 7% to 8% for the full year. Connors forecast client revenue would grow in the low-teen percentages for the full year but come in flat to down slightly in the second quarter due to a difficult comparison to last year, when Windows XP launched.

"Server" revenue grew 13.8% year over year to $1.59 billion. Server revenue is expected to be up in the midteen percentages for the full year, and 10% year over year in the second quarter.

"Information worker" revenue from Microsoft Office and Great Plains products grew 25.7% to $2.27 billion. The company reiterated earlier guidance for full-year information revenue growth in the low-teen percentages and forecast growth in the midsingle digit percentages in the second quarter.

MSN sales declined by $3 million to $427 million. MSN revenue was expected to enjoy full-year growth in the mid- to upper-single digit percentages. Excluding revenue from Expedia, MSN revenue grew 23%. MSN revenue is expected to fall shy of $2 billion for full year and under $500 million for second quarter.

Home and entertainment sales, representing Xbox consoles, games and hardware, increased 81.6% to $485 million. Microsoft had expected those sales to be up nearly 20% for the full year and up to about $600
million in the second quarter. Connors said home and entertainment revenue should enjoy growth in the high-teen percentages and should surge to roughly $1.5 billion in the second quarter, which includes the critical holiday season and should be a big test for Xbox.

Connors said PC shipments could be up slightly or flat in the second quarter compared to a year ago. "Demand for corporate IT infrastructure continues to be challenging," he added. "However, it has not
worsened significantly since we last spoke with you."